Sunday, May 8, 2011
RSI
Although I am not a great lover (far from it) of
technical indicators I do use some of them as an extra tool in my trading. I am
absolutely sure that you can see any indicator can show you in the charts. And
it is needless to say that all indicators are lagging and you should find your
ways (or follow mine) to determine where price is headed in the future. Still,
I do use indicators and today I wanted to give you a few thoughts on how you
can use rsi indicator in trading a trend and a range.
When you finish this article read my previous posts too:
The
first method: traditional overbought and oversold stuff
I have my own favorite methods and not always use
the classical ways of trading indicators. However, the first method is pretty
traditional and it is to look for overbought and oversold levels in a trend or
counter trend move. I do not have enough patience to explain about the values
of rsi (I will expand the post later), you can read about them in most forex
sites that deal with technical analysis. However, any value (if we use 14 day rsi) that is close to 30 and below the
level can be considered oversold and any value that is close to 70 or above the
level can be considered to be overbought.
This
would mean that if we are in a range you would
be looking how to sell a security if the indicator reaches 70 level and
you would be
looking how to buy a security if it reaches 30 level. In a trend the
indicator very
often goes beyond these levels (is overbought in an uptrend and oversold
in a
downtrend) for a prolonged period of time and is not a very reliable
indicator
to trade against the trend. It is however, pretty good to enter a trend
if the rsi shows overbought levels in a downtrend and oversold levels in
an uptrend.
If you looked at silver daily chart with Relative Strength Index at 14 on
you would see that on the 5th of May indicator reached oversold level with
a value of 28.89. We also see from the chart that silver has been in an
uptrend, which means that we should be looking for opportunities to seek how to
go long. So, you go to lower time frames for example 1 hour chart and search
for confirmations to buy there. I like waiting for 123 patterns on 1 hour or 4
hour charts to go back in the direction of the trend. Long bullish hourly
candles can also be an indication that a counter trend rally is over and we can
come back to long entries (See the chart below about the possibility of going
long in silver).
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Trading
hidden divergence
Another way to use the indicator, which I like and it is not a
very traditional way to do it is to wait for hidden divergence in order to go
back in the direction of a move (if you believe it is going to continue). Divergence
is basically a discrepancy between the action of price and the action of an
indicator for the price. In an uptrend, it means the price is going higher and
the indicator shows lower values. So, there would be a divergence if you saw
higher highs in a security and lower highs in the indicator. (See the example
below with aud/usd pair). When you see it in a range, it could be a good
possibility to think of shorting a security. Not a good idea to do it when a
long term uptrend is in place!
However, if you have a long term uptrend (or a swing
up) in place you wait for hidden divergence to enter the market. What you want
to see is again a discrepancy between price and indicator. This time (if we
take uptrend) the price makes higher lows and indicator makes lower lows. It is
a hidden divergence and you should look for opportunities to go up. A hidden
divergence usually forms when you have sharp correction in an uptrend or
downtrend and these present you with good possibilities to reenter the trend
with much favorable prices than you would pay if you traded a breakout of
higher highs in an uptrend or lower lows in a downtrend. When you see hidden
divergence formed in a trendy market it may mean that a counter trend move has
overextended itself and market participants will increase their positions in
the direction of a prevailing tendency. And so should you! Again you could wait
for 123 structure or other technical pattern which you would use as a reversal
signal in a counter trend move.
Best
time frames for hidden divergence in a swing
I
prefer using 4 and 8 hour charts for waiting of a
hidden diversion in a trend. These time frames are more accurate and you
have
less market noise in the indicator. I also reduce the noise by taking 21
period rsi instead of 14 period. The reason the same, the smaller the
period the more
noise you have. And if you look at 5 or 1 minute frames most of what you
see
will be noise. So, do not mess around with those minute charts. They are
good
for determining the best entry levels, but tell you nothing of a
prevailing
market trend and you make serious money by trading big moves. So, do not
lose
your focus in playing around with minute frame charts. Keep your focus
on
direction.
Conclusion
rsi indicator is one of the best among what is
currently available for a market technician. However, it should only be used as
a supplementary tool in technical analysis for defining overbought/oversold
levels in a range and in adding to a position in a trend after a correction
when hidden divergence is formed. Focus should be on larger time frame charts
and smaller time charts should be used only for determining best entry levels.
Disclaimer
Trading
financial markets carries a high level of risk, and may not be suitable
for all investors. All information on the blog is of educational nature
and cannot be considered as advice, recommendation or signals to trade
in any financial markets.
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